Trade options – a flexible and versatile instrument
In the 1970s, options were developed as a trading instrument to mitigate risks. Traders experienced high volatility and they started using options to hedge their positions. For newbies who are looking at trading opportunities beyond stock and bonds, options are an ideal instrument. You may have heard that options are risky. A newcomer may be confounded by the new concepts and parlance. However, in reality, options are less risky compared with stock trading. With a good understanding of how options work, you can discover a completely new world of opportunity to trade profitably.
You can hedge your risks and lend flexibility to your portfolio with trade options. Moreover, they derive their power from their versatility and an ability to interact with traditional assets such as individual stocks. Options are a type of derivative security. They are contracts that give the owner the right but not the obligation to buy or sell a contract at an agreed price before a certain date, which is termed the expiration date of the contract. They are called derivatives because the price is derived from something else. The right to buy is termed a call option and the right to sell is called a put option.
Options trading vis-à-vis trading in stocks
Buying and selling stocks may seem a simple step compared with options. However, based on how a trade compares in both cases, you will soon discover that trading in options is less risky and better than trading in stocks. Let us assume you want to buy 1000 shares at $50 a share, which would cost you $50,000 to make the purchase. You can hold on these shares as long as you want because there is no expiration on this and you can decide when you want to sell these shares. Receiving dividend is one of the ways you have earned profit from the shares. If the share price goes above $50, the value of your holding goes up but, if it goes below $50, you will make a loss.
Now, let us see what we can do differently by using options. In options, you have the choice of a call option, which gives the buyer the right to purchase the stock at a certain price. The price at which you choose to buy the shares would be the strike price and the closing date would be the expiration date for that option. You will have to pay a fee to buy the stock for the strike price. This fee is called the premium, which is a small amount that locks you into the contract. Several things will influence the call premium, the first thing being the selection of strike price. If the strike price is lower, there is more built-in value in that call option, which is called the intrinsic value. As the intrinsic value gets higher, you will pay more premium for the call option. The other factor that affects the premium is time value. The longer the time left for expiration, the more premium you will have to pay for the call. Further, the volatility of the stock will influence the cost of the option and an increase or decrease in stock volatility tends to result in an increase or decrease in the premium.
One option contract represents 100 shares of the underlying stock. Therefore, you will have to buy 10 option contracts to buy 1000 shares. You are picking up 10 options contracts representing 100 shares at a strike price of $50 and have two months left until expiration. During these two months, when the stock price increases, the call premium increases and you can sell the call for a profit. However, the risk here is that the call premium can decrease, which typically happens when the stock price falls, when you will have to sell the calls for a loss.
Options allow you to manage risks and benefit even in a falling scenario
Now, you can manage the risk and protect the stock against falling prices by using the put option, which allows you to sell the share. Just like call options, the variables affecting the premium of a put option will be time and volatility. In a put contact, when the stock price falls, you can exercise your option and sell the stock at the strike price and, when the share price rises, you can sell the share itself at a profit. Thus, you can see that, while stock trading allows you to benefit only from a rise in the stock price, options allow you to benefit even when the share price is falling.
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